LONDON, Feb 12 (Reuters) - U.S. sanctions on Venezuela’s state-owned oil company are tightening the global oil market and sending refiners around the world scrambling to find replacements for the country’s diesel-rich heavy and extra heavy crudes.

Venezuela’s heavy crudes, such as Merey, have few close substitutes, with the nearest being grades such as Brazil’s Marlim, Mexico’s Maya, Canada’s Bow River and Cold Lake, or Iraq’s Basra Heavy.

Most of those crudes have an even higher sulphur content than Venezuela’s, which will require extra processing to make fuels of acceptable quality, and in any event the quantities are limited in the short term.

Venezuela sanctions have arrived in a market that was already likely to be short of medium and heavy crudes because of U.S. sanctions on Iran and OPEC’s output cuts.

The major oil exporters in the Middle East Gulf (Saudi Arabia, Iraq, United Arab Emirates, Kuwait and Iran) market mostly medium and heavy crudes.

U.S. sanctions on Iran and Venezuela, together with OPEC’s output cuts, have therefore removed mostly medium and heavy oils from the market, leaving lighter grades relatively unaffected.

The result is that prices of medium and heavy crudes have surged relative to their lighter counterparts since the middle of January.

Mars, a medium crude grade from the U.S. Gulf, has moved to a rare premium over Louisiana Light Sweet. Oman, another medium crude, has moved to a premium over Brent, a light one.

DECADES OF FAILURE

Venezuela has the world’s largest proven oil reserves, amounting to around 300 billion barrels, ahead of Saudi Arabia on 265 billion and Canada at 170 billion (“Statistical review of world energy”, BP, 2018).

But the country’s oil industry has been in relative and absolute decline for the last 50 years as problems of producing and marketing its heavy crudes have been compounded by an unattractive investment regime and mismanagement.

Venezuela’s crude production slumped from 3.8 million barrels per day in 1970 to just 1.7 million bpd in 1985, recovering to 3.4 million bpd in 1998 before slumping again to 2.1 million bpd in 2017.

Venezuela accounted for 16 percent of OPEC output and 8 percent of world production in 1970 but those percentages had fallen to just 5 percent and 2 percent respectively by 2017 (tmsnrt.rs/2E4Pfb9).

The country’s very dense crudes, some of which barely float on water, are complicated to process and sell for a large discount compared to other producers.

Production has been hampered by corruption, political interference and lack of foreign investment and technology to maintain existing fields and develop new ones.

Like Iran, another founding member of the Organization of the Petroleum Exporting Countries, Venezuela’s oil industry has been blighted by mismanagement, unrest, political instability, diplomatic isolation and sanctions.

Output has gone into free fall as the country’s isolation has increased, shrinking from 2.4 million bpd in 2016 to 2.0 million bpd in 2017 and 1.5 million bpd in 2018, according to the Joint Organisations Data Initiative.

Venezuela was once a major oil exporter to the United States, but shipments have fallen from 1.4 million bpd in 1998 to around 500,000 bpd in 2018 (“Petroleum supply monthly”, EIA, Jan 2019).

Venezuela’s diminished importance in the global oil market and as a supplier to the United States has emboldened the U.S. administration to take a tough approach in attempting to oust the government of Nicolas Maduro.

Sanctions announced last month prohibit U.S. corporations and persons from financial transactions with state-owned oil company PDVSA.

The U.S. Treasury’s guidance, which appears deliberately unclear, has left many third-country buyers uncertain about whether they can do business with PDVSA without also falling foul of sanctions.

HEAVY OIL SHORTAGE

The U.S. administration likely calculated any fallout from sanctions on oil prices would be small given the limited volumes of crude involved and the expectation that the standoff would be resolved quickly.

But while Venezuela’s crude now accounts for a very limited share of the global oil market, it plays a much more important role in the niche market for heavy crude.

Venezuela accounted for 1 million bpd of heavy-sour crude production out of a worldwide total of 7 million bpd in 2017 (“World Oil Review”, ENI, 2018).

Heavy crudes are much harder to refine and tend to contain significant quantities of sulphur and other impurities that are costly to remove, which is why they sell at a hefty discount to medium and light oils.

For refineries that have invested in delayed coking units, however, heavy crudes can yield large volumes of middle distillates (gasoil, diesel and jet fuel).

Middle distillates are used mostly in freight transportation as well as manufacturing, mining and farming, and are particularly valuable late in the business cycle when economic activity is near to the peak.

Mid-distillates are especially prized at the moment with the forthcoming introduction of new bunker fuel regulations by the International Maritime Organization from the start of 2020.

In effect, sanctions have shifted the balance of global oil production in the direction of lighter crudes, at the same time that the economy and forthcoming regulations are pushing refinery demand towards heavier grades.

The sudden embargo on Venezuela’s exports has therefore sent refiners in the United States and elsewhere scrambling to find alternative supplies compatible with their equipment.

If refiners are unable to source enough heavy and extra heavy crude, they will buy the next best alternative, in this case medium density crudes, so the impact of sanctions is rippling through the entire oil market.